Last Thursday, the Financial Regulatory Reform Initiative’s Regulatory Architecture Task Force released a report entitled Dodd-Frank’s Missed Opportunity: A Road Map for a More Effective Regulatory Architecture. The report highlights a series of practical ways in which the U.S. regulatory structure could be streamlined and made more effective. One important way to do this is by refocusing prudential oversight more clearly on those institutions that pose the greatest systemic threat to the financial system.
Specifically, BPC’s report recommends raising the threshold at which bank holding companies are subject to enhanced prudential supervision, a level more commonly known as the systemically important financial institution (SIFI) threshold. Under the Dodd-Frank Act, that level was set at $50 billion in consolidated assets; BPC’s task force recommends increasing it to $250 billion. The task force also suggests that the threshold become “presumptive” rather than “automatic,” with the Financial Stability Oversight Council (FSOC) determining which institutions should be subject to enhanced standards according to a series of objective criteria. These changes would significantly increase regulatory effectiveness, reduce systemic risk and impose a more appropriate regulatory framework on mid-sized institutions.
As the report notes, enhanced prudential supervision requirements were included in Dodd-Frank so that “banks and non-banks that could generate substantial risk to the financial system by their failure would have a different and enhanced level of regulation applied to them.”1 Indeed, while there is debate over the specifics, there is a broad consensus that the largest financial companies should be subject to enhanced prudential standards given the systemic consequences that would result from the failure of one or more such institutions. Currently, these enhanced prudential standards include a combination of additional risk-based capital, leverage, and liquidity charges, debt-to-equity and counterparty credit limits, living will resolution planning, as well as annual regulatory stress testing by the Federal Reserve.
Finding the Right Threshold
The question, then, is not whether there should be enhanced prudential standards, but to whom they should be applied. Currently, there are 37 bank holding companies with assets greater than $50 billion that are subject to enhanced supervision, in addition to the three non-bank financial companies that have been designated as systemically important by the FSOC. These institutions vary widely in both size and the scope of their operations, from multinational financial conglomerates to banks with narrower business lines and regional geographic scope. This wide range of characteristics raises important questions about whether the current bank threshold for enhanced supervision is appropriate. In particular, the task force raises the concern that regulatory resources have been misallocated, with too much time spent on supervision of institutions that do not pose a systemic risk and insufficient attention to those that do. Indeed, just last week regulators implicitly acknowledged that fact when they set the new supplementary leverage ratio for banks at $700 billion in assets rather than $50 billion.2 Although identifying the appropriate threshold is difficult, the changes advocated by the task force make sense for two principal reasons.
First, when measured in terms of asset size, banks with assets of around $50 billion are relatively small. One would have to combine the assets of all 22 bank holding companies that fall between the current and proposed thresholds in order to arrive at an asset size equivalent to that held by the country’s largest bank. The six largest bank holding companies average $1.2 trillion in assets, while the average size of the 22 banks in the $50-$250 billion range is just one-tenth of that amount (for reference, the comparable medians are similar: $1.5 trillion and $108 billion respectively).3 Based on size alone, it is difficult to imagine that the collapse of any single institution below the $250 billion threshold would result in system-wide negative externalities.
Second, and perhaps more important, these smaller banks are generally not nearly as interconnected as the largest financial institutions. Most operate in distinct regions of the country and have limited exposure to foreign investments; in fact, nine out of every ten dollars these mid-sized banks hold are U.S.-based.4 Mid-sized banks – with a few exceptions – are significantly less integrated into the global financial markets than the largest institutions. They also typically generate the vast bulk of their revenue from traditional “boring banking” activities such as deposit taking and lending, not complex trading and investment activities.5 As such, it is extremely unlikely that the failure of any one of these banks would produce domino effects with systemic consequences for either the U.S. or international banking sectors.
Striking the Right Balance
These factors suggest that the threshold for enhanced prudential supervision is currently too low, placing unnecessary burdens on both the regulator of such institutions – the Federal Reserve Board – and the mid-sized banks themselves, who are hit relatively harder than their larger counterparts by the by the largely fixed compliance costs associated with enhanced prudential supervision. However, as the task force rightly concludes, raising the threshold is not a solution in itself. The $250 billion figure, much like the $50 billion threshold, is not a magic number separating systemic and non-systemic institutions. A bank below that threshold could potentially be highly interconnected with other financial institutions, and one above it could be a retail bank with a largely regional concentration.
As a result, the task force recommends that the new threshold be “presumptive” rather than automatic. While there would be a presumption that institutions above the $250 billion threshold would be subject to enhanced supervision, that presumption could be contested by the bank in front of the FSOC. Similarly, the FSOC would have the discretion to require any institution below the threshold to be subject to enhanced supervision. In both cases, the FSOC would weigh factors similar to those it currently uses in determining whether to designate a non-bank financial company as systemically important, such as the institution’s size, its interconnectedness, substitutability, leverage, liquidity risk and maturity mismatch.
This flexibility will allow regulators to evaluate systemic risk potential on a case-by-case basis, thus strengthening the FSOC’s role in system-wide oversight. Similarly, by raising the threshold, the Federal Reserve Board will be able to more efficiently train its resources on those institutions that present the greatest systemic risk potential. Both of these developments will make the financial system safer and sounder, while removing economically costly burdens on mid-sized banks that may make it more difficult for them to lend to businesses and consumers. In short, these changes to the enhanced supervision threshold would be a rare win for regulatory efficiency, financial safety, and the broader economy.
1 Richard H. Neiman and Mark Olson, “Dodd-Frank’s Missed Opportunity: A Road Map for a More Effective Regulatory Architecture,” Financial Regulatory Reform Initiative, Bipartisan Policy Center, April 10, 2014. Available at: https://bipartisanpolicy.org/sites/default/files/BPC%20Dodd-Frank%20Missed%20Opportunity.pdf.
2 Board of Governors of the Federal Reserve System, “Agencies Adopt Enhanced Supplementary Leverage Ratio Final Rule and Issue Supplementary Leverage Ratio Notice of Proposed Rulemaking,” April 8, 2014. Available at: http://www.federalreserve.gov/newsevents/press/bcreg/20140408a.htm.
3 Federal Financial Institutions Examination Council, “National Information Center: Top 50 HCs.” Available at: https://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx.
4 Dafna Avraham, Patricia Selvaggi, and James Vickery, “A Structural View of U.S. Bank Holding Companies,” FRBNY Economic Policy Review, July 2012. p. 73. Available at: http://www.newyorkfed.org/research/epr/12v18n2/1207avra.pdf.
5 Ibid. at 74.